Here We Go Again...

With negative news from super-heavyweights IBM and Chase Manhattan,
in addition to a collapsing junk bond market and faltering stocks
and currencies throughout Asia, as well as globally, Wednesday
was a critical juncture for financial markets. The euro traded
in an increasingly dislocated manner, energy markets were again
moving higher, and spreads began to widen significantly here at
home, in Latin America and throughout emerging debt markets. The
Dow opened down nearly 450 points and the NASDAQ100 had broken
through the key 3000 level. No mistake about it, a serious financial
event was in process; derivative players were certainly in dire
straights, especially as they were forced to hedge put options
in a collapsing market just two days before option expiration.
They needed a rally; they got it in a big way. From Wednesday's
low to today's highs, the NASDAQ100 surged 18%, the Semiconductors
28%, the AMEX Broker/Dealer index 13%, and the S&P Bank index 9%.
Microsoft surged 35% from Wednesday's low, while other key derivative
stocks such as Dell, Yahoo, and Intel jumped between 20% and 45%.
This wild surge cut year-to-date losses to 7% for the NASDAQ100
(52-week gain of 40%) and 5% for the S&P500. With the proliferation
of equity derivative trading, the relative outperformance of these
two key indices has been most opportune for the financial system.
At the same time, it is truly frightening to ponder the harsh reality
that this out of control marketplace has come to occupy such a
critical role in our nation's economy, as well as the global economy.

For the week, the NASDAQ100 and the Morgan Stanley High Tech indices
jumped nearly 6%, with The Street.com Internet index also adding
6%. The AMEX Biotech index surged 8%, increasing its year-to-date
gain to 86%. The Dow was largely unchanged, while the S&P500 gained
2%. The Transports added 2%, and the Morgan Stanley Cyclical index
gained 1%. The Morgan Stanley Consumer index had a slight gain,
while the Utilities declined 1%. The small cap Russell 2000 increased
more than 1%, and the S&P400 Mid-cap index advanced 3%. The NASDAQ
Telecommunications index added 1%. The financial stocks made a
strong showing, with the AMEX Security Broker/Dealer index surging
5%, and the S&P Bank index increasing 2%. Gold stocks dropped 5%.

Responding yesterday to a question from CNBC's Ron Insana, "if
you were President, what would you do in response to a financial
crisis?" Governor Bush stated that he would immediately "call
Alan Greenspan" and "talk about liquidity." For
good reason, Wall Street, Washington, and the media have come to
believe with religious fervor that any financial problem can be
quickly resolved by the largess of the Federal Reserve liquidity
machine. This perception has certainly played a major role in the
great U.S. bubble - a truly historic episode of "moral hazard." In
fact, behind the scenes I am sure there is indeed a movement afoot
to create additional liquidity to keep financial markets afloat.

There is, however, a critical aspect of contemporary financial
systems and economies that goes unappreciated by U.S. central bankers
and the bullish consensus, and we see this dynamic both globally
and certainly within the highly speculative U.S. financial system:

Liquidity seeks out inflation, while avoiding deflation like
the plague. This dynamic was made clear back in 1994/95 when
the Japanese central bank moved aggressively to create liquidity
in hopes of stemming accelerating deflationary conditions. Strong
action was taken to stimulate the economy and stabilize asset
values as well as the general price level. There was, however,
a major unexpected consequence: much of the liquidity avoided
the deflationary spiral in Japan, choosing instead to flee the
country in search of asset inflation overseas. Exactly such a
circumstance was found in the burgeoning (and infamous) "yen
carry trade," or borrowing at near zero interest rates to
take leveraged positions in higher-yielding securities in the
U.S. and Europe. A more recent example of liquidity's preference
would be the flight out of PC and Internet stocks and into subprime
and biotech issues. Sophisticated "hot money" speculators
recognize that PC companies are operating in a deflationary environment,
while inflation remains very prevalent in drug pricing, high-risk
lending and consumer finance generally.

The fact that liquidity seeks out inflation, while avoiding
deflation like the plague, poses an enormous, and I suspect
largely unrecognized, dilemma for central bankers, particularly
in the present environment. Clearly, Greenspan and Wall Street
have come to believe that any crisis can be averted by stoking
securities prices with a greater flow of liquidity - additional
money and credit/purchasing power. Certainly, Wall Street is
aggressively positioned with the "Greenspan Put" in
mind. And with our recklessly over leveraged and speculative
financial sector "hanging in the balance," the presumption
today is clearly "easy money" as far as the eye can
see. Yes, the Fed will feel increasing pressure to mitigate the
grave systemic stress developing after the bursting of the technology
bubble. The major consequence of continued credit excess, however,
will be more liquidity, or inflationary fuel, to sectors outside
of the cash-strapped telecom and leveraged-lending areas.

Sure, additional money supply and financial credit growth increases
demand for debt securities. Today, however, this additional purchasing
power avoids faltering companies and sectors in dire need of financing,
choosing instead Treasuries and securities from sectors where inflationary
pressures are still prevalent, such as mortgage-back and agency
securities. More buying of Treasuries only exacerbates market dislocations,
posing considerable problems for the leveraged speculators and
derivative players. Also, additional liquidity will avoid companies
like Xerox, and will instead go directly to the likes of Fannie
Mae and Freddie Mac - that are still aggressively expanding credit
and, accordingly, with underlying assets (mortgage loans and residential
real estate) remaining with a strong inflationary bias. While the
telecom sector increasingly struggles with what will be a devastating
credit crunch, the residential real estate market is awash in inflationary "easy
money." While many Internet companies will collapse as funding
runs dry, lenders will certainly line up to fund what will likely
be the $1 billion sale of the Bank of America building in San Francisco.
For now, office rents are inflating and liquidity seeks out
inflation. This is precisely what we mean by a distorted and
unbalanced economy.

Yes, the Fed and the financial sector can "reliquefy." But
what they and Wall Street do not appreciate is that, by its very
nature and certainly with the leveraged speculating community having
come to play such a dominant role throughout our financial system,
this "hot money" will gravitate to sectors where it will
only exacerbate already problematic distortions and imbalances.
Liquidity can be created. But, it will have a strong proclivity
against going where the Fed wants it to go - it will, instead,
prove destabilizing. Throwing only more liquidity at the household
sector in this environment of heightened inflationary pressures
and an unfolding energy crisis is a dangerous game. At a minimum,
it will add fuel for higher energy prices and only greater and
inevitably destabilizing trade deficits, with great risk to the
dollar. Stating the major dilemma in anther way: one big problem
currently is that the enormous tech/Internet/telecom sector, the
previous bastion for credit and speculative excess ("inflation"),
is in a serious liquidity crunch ("deflation"). A second
big and complicating problem is that we remain in the midst of
an historic credit-induced real estate bubble, with the real estate
finance superstructure presently the leading instigator of money
and credit excess ("inflation"). If you were liquidity,
where would you go?

On another subject, we have to take exception to last week's Current
Yield column in Barron's:

"Is it Fall 1998 all over again? Bond market participants
couldn't help but wonder last week as Wall Street's simmering
credit squeeze began to pinch. Corporate-bond spreads in the
U.S. and Europe widened sharply amid concerns over deteriorating
credit quality. And speculation about big losses in junk bond
trading slammed bank and brokerage stocks, including those of
marquee-caliber firms like Morgan Stanley Dean Witter, Goldman
Sachs and Merrill Lynch.

Things aren't nearly as bad as they were two years ago, however.
For one thing, there's far less leverage in the financial system.
In late 1998, Russia's meltdown caught hedge funds in over their
heads, prompting the Federal Reserve to cut rates and Wall Street
giants to bail out Long-Term Capital Management. And the global
economy isn't on the verge of recession. Asia's economies are
healthier, as are Latin America's. That means there's less reason
to think today's volatility in the credit markets pose a systemic
risk."

Actually, I strongly disagree with the analysis that today "things
aren't nearly as bad" or that "there is far less leverage
in the financial system" than in 1998. In fact, this statement
could not be further from reality - things are, regrettably, much
worse. First, let's dig into the leverage issue. Looking at Federal
Reserve data, total outstanding credit market debt has surged $4.4
trillion (20%) in the two-year period since June 30th 1998. Marketable
debt issued by the corporate sector increased by 30% to $4.6 trillion,
while household sector debt increased 19% to $6.7 trillion. Total
outstanding mortgage debt has surged $1.6 trillion, or 32%. And
more specific to financial system leverage, the financial sector
increased credit market borrowings by a whopping $2 trillion, or
34%, to almost $8 trillion. Within the financial sector, we see
that commercial banks have increased total liabilities (marketable
debt and deposits) by $933 billion, or 18%. Security Broker/Dealers
increased total assets by $270 billion, or 32%. Finance companies
increased holdings by $265 billion, or 34%. And, importantly, the
government-sponsored enterprises expanded assets by an astounding
$518 billion, or 44%. Not bad for two years.

Perhaps there are no acutely fragile hedge funds that have incorporated
outrageous leverage like LTCM, but make no mistake, there is unprecedented
leverage in our financial system - endemic over-leveraging that
has gone to a new extreme since the near meltdown in 1998. The
security brokers have much greater exposure today than they did
two years ago and the derivatives marketplace is much larger. Moreover,
I actually see the GSEs in the same vein as LTCM. They both have
strategies that superficially seem reasonable - they certainly "talk
a good story" and masterfully sell the concepts of New Era
finance, derivatives, "risk management," and sophisticated
strategies. But the bottom line is that these reckless strategies
revolve around interest rate arbitrage and absolutely egregious
leveraging. Looking at September 30th data from Fannie Mae and
Freddie Mac, we see that $33 billion of shareholder's equity now
supports total assets of $1.07 trillion. This, however, is not
the extent of these companies' exposure. Fannie and Freddie also
have enormous off-balance sheet liabilities as they have guaranteed
the "timely payment of principle and interest" on another
$1.26 trillion of mortgage-back securities not held in their immense
mortgage portfolios. So, for every $70 of (mostly mortgage) exposure,
they have $1 of shareholder's equity. And, since June 30th 1998,
Fannie and Freddie have ballooned total assets by $507 billion
(90%!), while shareholder's equity has increased $12 billion. Including
off-balance sheet guarantees, total exposure has increased $712
billion.

And while Wall Street and Washington trumpet how wonderfully these
companies are managed, I have come to the conclusion that this
GSE credit explosion is little more than a sophisticated scheme
- a current manifestation uncomfortably on the lines of the infamous "South
Sea Bubble" or the "Mississippi Bubble." With this
in mind, I have absolutely no doubt that this apparatus of financial
engineering and wanton credit excess will at some point collapse;
they always do. And the more monstrous these institutions are allowed
to become, the greater the risk that their eventual collapse brings
down the entire global financial system. This is no exaggeration
- these institutions make LTCM look miniscule. It is absolutely
appalling that these institutions are allowed to run unchecked
as risk grows by the week. There is also no doubt that continued
GSE excess exacerbates problematic distortions and imbalances to
the real economy and, eventually, to the American taxpayer who
will be left holding the bag. After all, the only way this scheme
remains viable, especially during times of heightened market stress,
is because of the implied guarantee from the U.S. government. It
is only with the assumption that the U.S. government would never
allow the failure of their sponsored enterprises that these institutions
command top debt ratings - no matter how egregiously over leveraged.
It is only because these institutions are assembly lines for triple-A
rated securities that they have unprecedented free rein to in the
marketplace to instigate bubble excess.

So, Here We Go Again… In what is becoming increasingly
reminiscent of 1998, we see that Freddie Mac increased assets by
almost $21 billion during the third-quarter, a 20% annual rate.
This compares to expansion of less than $7 billion, or 7% rate,
during the second quarter. Similar to Fannie, Freddie increased
(non-mortgage loan) "investments" by $9 billion (25%!)
during the quarter to $44 billion. During the past year, Freddie
has almost doubled the size of its "investments." For
the third-quarter, Fannie and Freddie combined to expand total
assets by $50 billion (20% growth rate), compared to $29 billion
during the second-quarter (12% growth rate). (It is no coincidence
that money market fund asset growth has accelerated over the past
15 weeks, expanded by $104 billion, or at a 21% rate) This was
the largest expansion since the turbulent fourth-quarter of 1998.
Year to date, "investments" have expanded at an annualized
rate of 50% to $99 billion. With these institutions now forcefully
purchasing mortgages, there should be little mystery behind the
collapse of mortgage yields to below 7.5% from almost 8.5% during
May, potent fuel for already overheated real estate markets. Clearly,
as goes the growth rate of GSE balance sheets, as goes credit market
liquidity.

We are not surprised that our politicians buckled and failed to
take any action to rein in the reckless activities of the Government-Sponsored
Enterprises. After all, Fannie Mae and Freddie Mac are said to
have the most powerful lobbies in the world. It is difficult, however,
to sit back quietly when members of congress "spin" the
situation and claim victory with yesterday's announcement of a
voluntary agreement with Fannie Mae and Freddie Mac. And many in
Washington and New York are claiming this resolves the situation…unbelievable.

Pulling an excerpt from the companies' release: "The companies
said they will hold more than three months' worth of liquidity
so their operations won't be disrupted during a financial crisis.
They've also agreed to implement a risk-based capital stress test
on an interim basis until a permanent capital standard be put in
place by its regulator, the Office of Federal Housing Enterprise
Oversight. The companies also agreed to publicly disclose results
of their analysis of interest rate risk sensitivity and publicly
disclose credit risk sensitivity analyses."

The "mood" in Washington was captured by comments from
Texas Congressman Ken Bentsen: "I think this proposal now
completes what has become a three-legged stool of regulation of
these two hybrid financial institutions - these two GSEs. You have
HUD, which has had regulatory authority over mission; you have
OFHEO, which was created in the '92 act in establishing a portfolio
regulation and capital risk standards regulation. And now through
this agreement you have market regulation, which in large part
should be predominant with financial institutions. And these two
financial institutions - which are congressionally created - have
become much more market oriented than perhaps they were in the
past. So I think this is a very good step for them. And I would
just say, I think this very well could lay to rest any questions
about whether or not there is proper oversight of the GSEs. Obviously,
Congress will have to continue to look at this. But it should also
lay to rest the issue that it is necessary for Congress to kill
the goose that laid the golden egg with respect to providing a
very stable secondary mortgage market in the United States, in
order to insure that there is not systemic risk. So I think Richard
(Louisiana Congressman Richard Baker) and Paul (Pennsylvania Congressman
Paul Kanjorski) have done a particularly good job of working with
the GSEs, and in doing so in a way that doesn't interfere with
the ability to continue to provide a stable mortgage product to
the American consumer. So I am quite hopeful that what is being
done today will be well accepted by the market and will work."

"Lay to rest" that there is "proper oversight," you've
got to be kidding! First of all, these companies can absolutely
not be trusted to rein in reckless excess with some voluntary agreement
- NO WAY! They have proven time and again that they are beholden
to Wall Street and the perpetuation of the bubble, not the American
taxpayer. Indeed, and as we are seeing again presently, it should
be noted that they expand their leverage most aggressively specifically
during times of acute financial instability. They are much too
leveraged to take this liberty. This is a dangerous game of financial
Russian roulette, and one of these days one or all of these institutions
will "take a bullet." Moreover, Congressman Bensten is
most incorrect that there is market regulation at work here. There
is anything but. These institutions, with their implied government
guarantee, operate specifically outside of market discipline. And
it is complete nonsense to look to Wall Street to discipline these
lenders - the leading instigators of credit excess and the critical
liquidity backdrop for the leveraged speculating community. It's
like asking addicts to regulate the drug pushers. Yea, that will
be a success. The bottom line remains, Wall Street and the GSEs
are a dangerous combination, and politicians are complicit…financial
historians will not be kind.

In regard to regulation, we did note a troubling passage from
an article back in the June issue of Bloomberg Magazine - Fannie
Takes on Its Foes - written by David Gillen: "His (Armando
Falcon, director of Office of Federal Housing Enterprise Oversight/OFHEO)
office has worked up a test that uses assumptions about interest
rates and mortgage defaults to determine if Fannie and Freddie
have adequate capital. Using 1997 financial statements, it found
that Freddie Mac was adequately capitalized but that Fannie Mae
came up $3.7 billion short of Falcon's standard. He promises an
updated report this year, but he says he can't get the money he
needs from Congress to keep up with the galloping companies…Fannie
Mae argues Falcon's test is confusing and riddled with errors. 'It
simply doesn't work,' Raines say. Fannie and Freddie have suggested
ways to improve it. Not surprisingly, many of those proposals would
reduce the amount of capital the companies must hold." Publicly,
Mr. Raines like to trumpet that Fannie Mae is closely regulated.
Right…and the taxpayer should take comfort from a voluntary
agreement.

It is an absolute outrage that Congress fails to provide OFHEO's
Mr. Falcon funding to update his stress test. Keep in mind that
since 1997, total GSE assets have mushroomed by more than $750
billion, with off-balance sheet increases putting total increased
exposure easily over $1 trillion. These institutions have also
developed into major derivative players, another ill-advised experiment
that will not end well. All considering, the American taxpayer
deserves at least an updated stress test, and it is not either
in Mr. Raines' or Freddie Mac's Mr. Brendsel's place to decide
if the test is to his liking.

The voluntary agreement also calls for the two companies "to
strengthen their capital cushion against sudden losses by issuing
publicly traded subordinated debt on a semi-annual basis. This
debt issuance will allow the companies to have core capital and
subordinated debt to equal or exceed 4 percent of their assets
after a three-year phase-in period." Well, to begin with,
why don't we give a bit more protection to the American taxpayer
with a moratorium on stock buybacks? Fannie Mae purchased another
5.4 million shares during the third quarter. This makes for a total
of 25.2 million shares repurchased during just the past three quarters
- "more than three times the number of shares repurchased
during the comparable period in 1999."

Since I am critical of Washington on this issue, I am compelled
to offer up 10 initiatives that I recommend be put in place immediately.
I won't hold my breath.

3) Do not use derivatives - (no counterparty risk for the U.S.
taxpayer!)

4) Terminate stock buyback programs

5) The Federal government should immediately and completely
disavow the implied guarantee (give market discipline a chance!)

6) Terminate all non-mortgage loan assets (stick to their charters!)

7) Terminate subprime and ultra-low down payment lending (too
risky for the American taxpayer!)

8) Limit the use of mortgage insurance - (only a facade of meaningful
protection)

9) Provide absolute transparency, on a timely basis, on what
is being purchased in the marketplace (protect the integrity
of U.S. financial markets!)

10) Give Mr. Falcon at OFHEO requested resources so he can do
his job!

On another subject, it is worth underscoring the unfolding debacle
in the high-yield bond market, and we believe high-risk lending
generally, and how investors and speculators are fleeing the sector.
Included above are charts from three major high-yield funds, not
to highlight individual fund performance, but to illustrate the
nature of the current liquidation. Last Friday Heartland Advisors
marked down the value of two their high-yield municipal bond funds.
The net asset value of the High-Yield Municipal Bond Fund was reduced
70% after management revalued security holdings.

From today's San Francisco Chronicle (Harsh
Lesson in Muni-Bond Funds): "Here's what happened: Last
Friday, Heartland changed the way it values bonds in its two
high-yield muni funds. Instead of relying solely on an outside
pricing service -- Interactive Data/Financial Times, the same
one many other funds use -- Heartland said it would 'consider
factors and information in addition to prices' provided by Interactive,
formerly called Muller Data. This change resulted in a drastic
markdown of the share price of two Heartland funds…In a
supplement to its prospectus, Heartland said it made the change 'because
of a current lack of liquidity in the high-yield municipal bond
markets generally, and because of credit quality concerns and
a lack of marketmakers, market bids' and comparable trades."

With the high-yield sector faltering generally, the fund began
to mark down the prices of some of its bonds. Then, "to meet
redemptions, the fund had to sell some of its bonds and found out
they weren't worth as much as they thought." What had been
considered market prices for the calculation of investors' wealth
were nowhere close to where the actual securities could be sold
in the marketplace. This is quite pertinent for financial markets
generally, as when funds are flowing into an asset class the entire
sector can be valued based on "last sale" and liquidity
conveniently assumed. The situation changes abruptly, however,
when fund flows reverse and liquidity comes at a great premium.
Stock investors take note…

Well, in conclusion, this week the leveraged players definitely
found themselves in "hot water" once again. Typically,
that means it's time for, Here We Go Again - "reliquefication." Yet,
we don't see it working this time, especially after the last episode
was allowed to run so out of control as to create unprecedented
liquidity for a final wild speculative blow-off encompassing the
Internet/telecom/technology bubbles. Today, the consequences of
previous excess are a great and escalating burden. We actually
do agree with the Barron's columnist in one area; the global economy
is not today heading for recession, while economies throughout
Asia and Latin America are booming, for now. But, let us not for
one second forget that the underlying financial systems are extremely
fragile at best, and likely hopelessly impaired. While economies
boom, the financial foundation could not be more precarious. In
a critical difference from 1998, our domestic financial system
is in the midst of an unfolding credit debacle. Importantly, the
crisis here at home in 1998 was mainly due to forced liquidations
in the leveraged speculating community and resulting systemic illiquidity.
Such a crisis could (and was) resolved through aggressive reliquification
(particularly from the GSEs) and lower interest rates from the
Federal Reserve - shift the leverage away from the troubled speculators,
and then make the environment conducive for the leveraged community
to continue to play. The environment was made "right" for
leveraged speculation, and the game was set in motion for a final
wild fiasco. It will not be possible to "right" the unfolding
credit debacle, only exacerbate it.

There is another key aspect that made the 1998 environment conducive
to a system-wide "reliquefication." Importantly, to achieve
credit excess takes both willing borrowers and lenders. For liquidity
to "stick," it must get in the hands of aggressive spenders.
Don't underestimate the role played in the 1998 "reliquefication" process
by having hundreds and even thousands of individuals and companies
with pie-in-the-sky ideas to create enterprises from the Internet
and telecom "revolution." They were like mountains of
tinder waiting for a match - more than willing to borrow and spend
in historic proportions. On the other side, liquidity found a similar
tinderbox with manic behavior overwhelming a bloated banking, investing,
and speculating community who absolutely fell over themselves to
provide capital and speculate like there was no tomorrow. It was
an extraordinary confluence of unprecedented liquidity, exciting
new technologies, and raw unadulterated emotion. It was a once
in a lifetime phenomenon - an historic mania. Those days are over.
Investors' confidence has been irreparably broken in the Internet
and telecommunications sectors, and I have no doubt that herein
lies the catalyst for the piercing of the Great U.S. Bubble.

Quoting from Charles Kindleberger's masterpiece "Manias,
Panics, and Crashes:" "Causa remota of the crisis is
speculation and extended credit; causa proxima is some incident
that snaps the confidence of the system, makes people think of
the dangers of failure, and leads them to move from commodities,
stocks, real estate, bills of exchange, promissory notes, foreign
exchange - whatever it may be - back into cash…To the extent
that speculators are leveraged with borrowed money, the decline
in prices leads to further calls on them for margin or cash and
to further liquidation. As prices fall further, bank loans turn
sour, and one or more mercantile houses, banks, discount houses,
or brokerages fail. The credit system itself appears shaky, and
the race for liquidity is on." (Thanks Gary!).